Introduction
According to the definition presented by Borensztein and Gregorio (1997), foreign direct investment (FDI) is the process through which a corporation directly invests in a nation other than its parent country. On the other hand, Graham (1991) defined foreign direct investment as the process through which a company purchases or constructs tangible assets in a foreign nation.
These assets can be in the form of land, processing plants, machineries, equipments, buildings and so on. From these definitions, it is evident that FDI is a process through which a corporation invests in a foreign counry. In the process, both the corporation and the host nation benefit from this process in terms of economic gains.
The concept of foreign direct investment has been present for several decades now. Between 1985 and 1988 for instance, foreign direct investment within the United States of America increased from $47 billion to $139 billion (Graham, 1991). This remarkable increase in foreign direct investment was attributed to the high level of commercial inflow within the nation.
Toyota is a prime example of a company that increased its investments in the automobile industry in the United States during the 1980s. As a result, therefore, the level of foreign ownership in the United States has increased tremendously. On the other hand, foreign direct investments have facilitated the economic growth of many countries especially in developing nations.
Despite the fact that foreign direct investments do not have a huge impact on the capital gains of these nations, their resulting impacts on their economic growth has been changing over the years especially because there are alternative sources of finance to support FDIs in developing nations.
Given these facts, therefore, this paper will focus on the impacts of FDIs on the virtuous circle of economic development. To achieve this, the paper will analyze the impacts that FDIs have on the economy of a given nation and the resultant effects.
The Impacts of FDI on the Host Nation
In the modern world, FDIs play an important role in maintaining and developing the economies of developed nations, emerging economies, countries that are in transition as well as developing nations (Tulug, 2004). FDIs increase the level of employment within the host nation, bring about modernization and technological development, enhance the level of international trade, increase the level of competition among domestic companies and play a critical role in the development of human capital formation.
Other than achieving economic success, FDIs are also helpful in achieving social needs of host nations. Through social corporate responsibility schemes, FDIs can introduce modern technologies that are safe for the environment. At the same time, these corporations can start up programs that aim at alleviating common social problems such as drug abuse, HIV/AIDS prevention and management and so on. However, the success of FDIs highly relies on the policies that have been put in place by the host nation.
These policies are essential in determining the relationship that will exist between the corporation, the host nation and the native population. The presence of well-defined policies is thus essential to ensure that the roles of each stakeholder are as well as the goals and objectives of the initiative have been clearly defined. Poor policies on the other hand might reduce the profitability of FDIs.
The balance of payments might also be affected. Consequently, conflicts might arise between the host nation and investing corporations. At the same time, the native community might have negative attitudes and perceptions towards FDIs especially if they do not benefit either directly or indirectly from them.
Therefore, to ensure that FDIs are successful in the short run and in the long run, a balance needs to be achieved between the benefits and shortcomings that can be accrued. It is as a result of this fact that several models have been developed to ensure that a virtuous circle of economic development is achieved. These models will not only guarantee that the goals and objectives of that have been set up through FDIs are achieved but also the economy of the host nation grows and develops at a remarkable rate.
FDI and Economic Growth
It has always been asserted that FDIs play a critical role in increasing the level of productivity and income in the host nation. However, it is difficult to ascertain precisely how FDIs achieve these goals (OECD, 2002). From studies that have been conducted, it is evident that FDIs have a huge economic impact as compared to local investments within the host nation.
Thus, for FDIs to be successful, they have to venture into the market and the economy of the host nation as Multinational Enterprises (MNEs) (OECD, 2002). However, the effect that MNEs have on the economy of developing nations is somehow different.
As Easterly (2003) asserted, the level of economic growth in developing nations is relatively low in terms of the impacts arising from MNEs as compared to the economies of developed nations. This trend has been attributed to the fact that fact that the level of education, technology, and infrastructural development in developing nations have not reached an optimum level to enable their economies to benefit fully from FDIs.
At the same time, the impaired financial markets of developing nations act as a barrier to economic development. Therefore, to achieve a virtuous circle of economic development, it has always been advised that either MNEs should initiate and be involved directly or indirectly in processes that will result in the development of infrastructure and improvement in the financial sector in host countries.
FDI and Trade
The goal of any nation is to achieve economic sustainability in the short run and in the long run. Industrialization is one of the avenues that play a critical role in achieving this goal. The level of industrialization in developing countries is very low. These nations import more than what they export. Such nations will therefore benefit from inward FDI contributions. Inward FDI is essential as it integrates the economy of developing nations by enhancing their level of foreign trade.
Through MNEs, developing nations tend to develop strong international networks in different industrial segments. Ultimately, these networks will boost the manner and level in which developing nations distribute, market, and sell their products at local and international levels. However, for all this to be realized, host nations need to have sound policies that will attract MNEs into their countries and support import and export processes (OECD, 2002).
To support the trading activities of host nations, host nations need to improve their level of exports to ensure that a desirable balance of payments is achieved. Through inwards investments, FDIs can overcome the financial constrain of host nations through resource endowments (OECD, 2002).
Here, MNEs explore and utilize the natural resources present in the host nation in a sustainable, effective and efficient manner hence increasing exports. The establishment of export processing zones (EPZ) has also enhanced the level of trade between host nations and the international community by increasing the level of imports and exports. From this analysis, therefore, it is evident that FDIs play a critical role in enhancing the trade within host nations.
FDI and Technology Transfers
Technology transfer has always been regarded as the most important contribution of FDIs to host nations (OECD, 2002). In most cases, MNEs have superior technology as compared the domestic industries. Therefore, with the presence of modern technology, the processes of producing, distributing and salling of goods and services within and outside the host nation will be enhanced.
Vertical integration is one of the channels through which technology spillovers from MNEs can become beneficial within the host nation. Here, MNEs impart the knowledge regarding new technologies to suppliers and purchases within the host nation through training, and provision of technical assistance that will ultimately modernize and upgrade the production process.
In the process, the quality of goods and services produced within the nation are improved. Horizontal spillover is also another channel through which MNEs can introduce new technologies within the host nation where other firms within the same industry will benefit. However, due to competition, the rates of horizontal spillovers are usually low.
However, for the host nation to benefit from technology transfer, the new technologies that have been introduced by the MNEs need to be in line with its business operations (OECD, 2002). Consequently, the difference in the level of technology between MNEs and domestic industries needs to be low. In the case where this difference is wide, firms within the host nation may fail to fully absorb the newly introduced technologies.
FDI and Human Capital Enhancement
Unlike the other FDI benefits that have a direct impact on the economy of the host nation, the impact that FDIs have on human capital investment is indirect. Consequently, it has been identified that MNEs play a minimal role in enhancing human capital within the host nation (Tulug, 2004).
It is thus the responsibility of the government of the host nation to ensure that its population is highly qualified and skilled to provide the established MNEs with the human capital that they require to support their operations. Therefore, scholars regard this practice as a strategy for host nations to attract FDI in their countries.
However, once MNEs have been established, they usually offer training and extension services to their employees. This is essential as it improves the skills and knowledge of the local population. As Borensztein and Gregorio (1997) asserted, there are individuals who use the skills, knowledge, and experience that they have acquired from MNEs to start up their own enterprises.
However, just like in the case of technology, the education gap between MNEs and the host nation should be minimal to ensure the spillover process is effective and successful in the short run and in the long run. To achieve this, it is advised that the host nation should educate its people to meet the skills and requirements that might arise as a result of setting up MNEs.
FDI and Competition
Through FDI, MNEs exert a lot of pressure on the host nations’ markets. Competition always exerts pressure on the firms that are currently operating in a given market. Therefore, the entrance of MNEs in a given industry will greatly enhance the level of competition the respective industry. However, it has always been stated that due to the influence that they have, MNEs outcompete domestic firms.
This eventually leads to their exit of domestic firms from the market (OECD, 2002). However, recent results from empirical studies that have been conducted by several scholars reveal that increased competition has positive impacts on the economy of host nations since it increases the level of productivity, reduces the selling price, and supports the equitable distribution of resources within the industry.
All these factors play a critical role in establishing a stable and sustainable economy in the short run and in the long run. Therefore, host nations need to come up with policies that will increase the ease at which MNEs can enter into their markets.
Conclusion
In the modern economy, FDIs play a critical role in the development and growth the global economy. However, developing nations have not fully benefited from the presence of FDIs within their economies. Therefore, with proper policies in place, FDIs will play a critical role in enhancing trade in developing nations at national and international levels, improve their level of technology, enhance their human capital, and increase the level of competition.
As a result, their production levels will be increased and firms will operate in an effective and efficient manner hence supporting economic growth and development through maximization of profits, improved balance of payments, stability of domestic industries as well as MNEs and an increased support from the local community. This will ensure the sustainability of the host nation’s economy in the short run and in the long run.
References
Borensztein, E and Gregorio, J 1997, How does foreign direct investment affect economic growth. Web.
Easterly, W 2003, ‘How much do distortions affect growth’, Journal of Monetary Economics, vol. 32 no. 1, pp. 187–212.
Graham, E 1991, Foreign direct investment in the United States, Institute for International Economics, Washington DC.
OECD 2002, Foreign direct investment for development: Maximizing benefits, minimizing costs. Web.
Tulug, O 2004, ‘What drives foreign direct investment into emerging markets’, Emerging Markets Finance and Trade, vol. 40 no. 4, pp. 101-114.